We all have a friend who just seems to be incapable of spending their money wisely. They make impulsive purchases on things they don’t need. They invest in the stock market, but they panic sell when stock prices dip and buy them when they’re too high. Chances are, these friends are likely some of the wisest people we know. Financial mistakes may seem like something that stems from a lack of knowledge/intelligence, yet history repeatedly shows us that even the most highly educated individuals often make poor financial decisions. The study of behavioural economics shows just why cognitive biases and emotional responses frequently override rational thinking, leading even smart individuals to make irrational financial choices.
One of the main assumptions of the traditional economic theory developed by Adam Smith was that all humans behave as rational decision makers, who carefully weigh the costs and benefits of each transaction before reaching upon the best possible decision. Reality, however, is far from the same. Research done by Daniel Kahneman suggests humans rely heavily on mental shortcuts that can simplify and speed up decision making, however, they introduce a lot of errors. We usually rely on our fast, intuitive thinking to make financial decisions, especially under uncertainty, making us vulnerable to bias, and leading to irrational decisions.
So why do intelligent people make so many mistakes financially? Well there’s a few reasons. To begin with, we have something called “analysis paralysis” in investing, or simply, overcomplicating things. Highly educated people tend to research every investment opportunity completely, down to the finest details. Financial markets are inherently quite uncertain, but they seek certainty in every decision they make, and by being overly perfectionist in scenarios, continually waiting for the “perfect” time to invest, they fail to take action at the right times. Furthermore, we often see that Intelligence pushes you to the idea that complex problems require complex solutions. Oftentime, even the most difficult tasks have the simplest solutions, yet they simply aren’t interested in finding simple answers.
In Ken Burns’ 2015 documentary “Cancer: The Emperor of All Maladies,” Robert Weinberg, a brilliant cancer researcher at MIT, perfectly explains why highly intelligent people like himself aren’t interested in simple solutions, even if they’re effective:
“Persuading somebody to quit smoking is a psychological exercise. It has nothing to do with molecules, genes and cells. And so people like me are essentially uninterested in it, despite the fact that stopping people from smoking will have vastly more effect on cancer mortality than anything I could hope to do in my own lifetime.”
This perfectly fits into the scenario of the stock market as well. In day trading, smart people sometimes think they can beat the market just by being clever and doing a lot of analysis. But as the writer of “Rich Dad, Poor Dad” argues, this can actually lead to losing money, because success in trading is more about staying calm and keeping things simple.
Perhaps the most intriguing of all, studies find that intelligent people often are more prone to making purely emotional financial decisions, despite their analytical capabilities. This can be attributed to the fact that the brain processes financial decisions through multiple systems: the analytical neocortex and the emotional limbic system. Under pressure, the limbic system often takes priority over rational thinking. They allow cognitive biases such as overconfidence/fear to override their rational analysis of situations.
Thus, financial mistakes usually don’t stem from ignorance, but are deeply rooted in the human mind’s fundamentals, from how we process information and respond to uncertainty. Simply being intelligent can’t counteract these biases. However, we can train ourselves to make wiser financial decisions by learning to recognize the feelings of anxiety, fear or excitement that can often cloud our judgement.
